“Ask the Attorney” – Types of Angel Financing

by Scott Edward Walker on February 17th, 2010

Introduction

This post is part of a weekly series called “Ask the Attorney,” which I am writing for VentureBeat (one of the most popular websites for entrepreneurs). As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese). Cheers, Scott

Question

We launched our company about six months ago, and we have a couple of angel investors lined-up for about $300,000. We don’t know if we should sell them common stock or preferred (they want preferred). I’ve been reading some stuff on the web that recommends issuing convertible notes. What do you recommend? Thanks!

Answer

This issue comes-up all the time. In short, I recommend that you issue convertible notes. Below are the advantages and disadvantages of each choice from the founders’ perspective.

1. Common Stock. The advantage of issuing common stock is that it is relatively quick, simple and inexpensive. All you need is a short subscription agreement and perhaps a stockholders agreement. In addition, from the founders’ perspective, it puts the angels in the same boat as they.

There are four disadvantages: (i) you will need to value the company, which (as discussed below) can be difficult and may lead to the founders’ substantial dilution; (ii) you’re likely to get substantial push-back from sophisticated angels — who generally will not agree to common stock because they don’t think their money should put them in the same boat as the founders; (iii) there may be tricky tax issues depending upon the timing of the investment — e.g., if you and your co-founders paid a nominal price for your shares of common stock and the angels pay substantially more for theirs shortly thereafter, the IRS may question how the value of the stock could have increased so much and may deem the shares issued to the founders a form of compensation; and (iv) it may cause potential problems with respect to stock option grants because the value of the shares of common stock will be established.

2. Preferred Stock. Preferred stock is extremely favorable to the angels. The only advantage from your perspective is that the interests of the founders and the angels are aligned. Specifically, there is no incentive on the angels part (unlike if they were holding convertible notes, as discussed below) to keep the valuation of the company low in the Series A round.

The disadvantages to issuing preferred stock are significant. First, it is relatively time-consuming, complicated and expensive. Indeed, legal fees can be in the neighborhood of $20,000 or more if the preferred stock has all the “bells” and “whistles.” And second, as noted above, valuing the company at such an early stage is difficult and often leads to protracted negotiations and substantial dilution to the founders.

3. Convertible Notes. The issuance of convertible notes is often viewed as a reasonable compromise between issuing common stock and issuing preferred stock. In essence, it is a form of “bridge” financing – i.e., it is designed to provide the company with sufficient funds to get to the first professional (i.e., “Series A”) round, at which point, the notes would automatically convert into preferred stock at a discount (typically 20%).

The advantage of issuing convertible notes is that it is relatively quick, simple and inexpensive; all you arguably need is a short note. As discussed above, the other significant advantage is that it will defer the company’s valuation (i.e., the pricing) until the Series A round. By issuing convertible notes, you “kick the can” to the Series A round when the valuation picture would be clearer.

The disadvantage of issuing convertible notes is that, as noted above, the founders’ interests and the angels’ interests may not be aligned because, again, it’s in the angels’ interest for the Series A valuation to be low. Indeed, angels who think they can make a significant contribution to your company (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating. Accordingly, if the angels do agree to the issuance of convertible notes, they will often push for a valuation “cap.”